Execute A Strap – Profit From Increased Volatility

Introduction To A Strap Option Strategy

The strap is an options strategy with a bullish bias on the underlying security. In fact, the strap is a slight variation to the straddle strategy. The long straddle strategy involves buying an at the money put and an at the money call with the same strike price, expiration date and derived from the same underlying security. The strap however is simply a straddle with an additional at the money call. Hence the strap involves buying 2 at the money calls and 1 at the money put with the same expiration date, same strike price and derived from the same underlying security.

Strap – A Net Debit Trade

The strap involves the buying of options only. Hence, executing a strap will result in a net debit.

Involves Higher Commissions Than Straddle

The strap requires more option contracts than a typical straddle. Hence, commissions paid to execute a strap is higher than that to execute a straddle.

It is important to conduct economic, fundamental and technical analysis. Some economic reports may cause increase in market volatility. Fundamentally, the price of the underlying security should be worth a lot more than it currently is. Perhaps, the price of the security should trade at $40. However, it is currently trading at only $25. An options trader may expect an increase in quarterly earnings or dividends that will cause prices to rise.Study the charts can back test to check how the underlying security reponds to certain events such as earnings or interest rate hikes. Some suggested chart patterns to look out for are:

The idea is to execute the trade well below the breakout to the upside or the downside.

The trader that executes the strap strategy expects high volatility of the underlying security in the short term. He also believes that there is a higher probability of the price of the underlying security going upwards than downwards. While it is classified as a neutral options trading strategy by many, it has a slight bullish bias which explains the fact that more long calls are used than long puts in this strategy.

Examine the option chain to select options for the construction of the strap. Remember to select options of the same strike price. Often times, you may not be able to find at the money options exactly.

The loss of the strap is limited to the total premiums paid for the options. The maximum loss occurs when the price of the underlying security is equal to the exercise(strike) price of the long puts or calls at expiration date.

The profit potential of a strap is unlimited. If the price of the underlying security makes a significant move in either direction such that the profits on the long calls or long puts exceed the premiums paid, then the options trader will earn a profit. Since there are more long calls than long puts, the trader will experience greater profits when the price of the underlying security swings upwards. If you examine the risk reward graphs , you will see that the gradient is greater when the price of the underlying security increases.

There are 2 profit scenarios. They occur when the price of the security goes up or down.

A profit is realisable when the exercise(strike) price of the call or put + total premiums paid for options × 1/2 is less than the price of the underlying security.

A profit is also realisable if the exercise(strike) price of the put or call less total premiums paid is greater than the price of the underlying security.

The above formula is used when the price of the underlying security goes up. If a negative number results, it means that the trade is loss making at that particular price point( the trading price of the underlying adset)

The profit can also be calculated as :

Exercise price of put or call – price of underlying security – total premiums paid for the options

The above formula is used when the price of the underlying security goes down.

With an estimate profit based on a target price reached and maximum loss, calculate the risk and reward ratio to find out the trade’s attractiveness. Insist on a high potential reward for every dollar of risk taken. Ask yourself this: Would a long straddle or a strip make more sense instead?

Price of underlying < downside breakeven point – If the price of the underlying security falls below the lower/downside breakeven point, the trade can be offset for a profit. An options trader can also decide to sell to close the put and hold onto the call options for a price reversal in the underlying security.

Downside breakeven point < Price of underlying < Upside breakeven point – If the price of the underlying security trades between the downside and upside breakeven points, closing out the position would incur the trader a loss. If the trader assesses that there is little probability that the price of the underlying security will make a significant move from there, he can choose to close the trade and incur the loss. The maximum loss is equal to the premiums paid for the options.

Price of underlying > Upside breakeven point – If the price of the underlying security moves above the upper/upside breakeven point, the trader can close out the trade totally. If he is of the view that there will be a price reversal, he can close the call position for a profit and hold the worthless put to profit from the price reversal.

Example Of A Strap

The price of TTT Corp is trading at $50. An options trader executes a strap by buying 1 December 50 put at a premium of $200 and 2 December 50 calls at a premium of $200 each. Since each contract cost $200 each, the total premium paid to initiate the trade is:

$200 × 3 = $600

If the price of TTT trades at $60 at expiration, the gain on each call would be :

($60 – $50) × 100 – $200 = $800

The gain on both call contracts is : $800 × 2 = $1600

The net profit to the trade is thus:

$1600 – $200 = $1400

The other way to calculate the profit is to take the calls and subtract the premiums paid from it.

$1000 x 2 – $600 = $1400

If the price of TTT trades at $40, the gain on the put is:

($50 – $40) × 100 – $200 = $800

The net profit is thus :

$800 – $200 × 2 = $400

You can also subtract the premiums paid from the intrinsic value of the put at expiration to find out the net profit.

$1000 – $600 = $400

As you can see a $10 increase results in a greater net profit as compared to a $10 decrease in underlying security price.

Strip, Strap & Straddle

The strip and the straddle are comparable strategies, with similar payoff profiles.